Understanding Market Expectations Using The VIX | Barita Insights | May 10, 2022

Introduction
You may have heard pundits in the financial media talk about the VIX or “fear” index and it may seem a bit esoteric, with the discussion reliant on industry jargon with little explanation of what it really means in simple terms. Professional investors rely on a broad range of tools and data sources as they seek to stay ahead of the market and the VIX may shed some light on the general expectations of market participants. In this article we’ll explore what the VIX is, what it means for investors in the market and how to possibly make more informed decisions about risk using this tool.

What Is The VIX
The VIX is short for the Chicago Board Options Exchange (CBOE) Volatility Index and it is a real-time measure of expectations of how much the stock market will move around relative to its average over roughly the next thirty days. As such, it is not intended to provide insight on the direction of the market, but how volatile it is expected to be as the name suggests. Therefore, a higher VIX reading implies a greater expectation of change in price in the short-term, whether higher or lower and vice-versa.

The index is calculated based on the prices of options on the S&P 500 index (SPX) which is often seen as a proxy for the overall market due to the scale of the companies that comprise the index. Options are contracts that give the holder the right but not the obligation to buy or sell a particular security, at a specified price, up to, or on the contract’s expiration date. As such, in a sense, options function as “insurance” on a security’s price movement. That being the case, if traders expect larger movements in stocks, they will be willing to pay a higher price for this insurance. The expected volatility can be calculated using the price, time to expiration and other market data. Using a basket of SPX options with an expiry of more than 23, but less than 37 days, a weighted average annualized volatility is calculated, which can be interpreted as the expected standard deviation of the SPX.

What It Means for Investors
As stated above, the VIX is an annualized figure, therefore the true one month expected move will have to be estimated from it. To do this we divide the annualized figure by the square-root of twelve to get a monthly estimate. Therefore, if the VIX is at 15, this means that based on SPX option prices, the market is expecting a one standard deviation move of roughly 4.33% for the month. Expressed differently, the market is expecting that there is approximately a 68% chance that the change in the SPX will be within 4.33% and a 95% chance that the change will be within 8.66%, which represents two standard deviations.

How To Interpret The VIX
There tends to be a negative relationship between the VIX and the S&P 500 as most investors are long-only and do not short sell. Therefore, the demand for insurance will be skewed towards protecting downside moves in stocks. Against this backdrop, low or declining readings in the VIX are associated with relative calm in the markets, indicating the markets are entering a period of relative stability and it may be ideal to skew your portfolio more towards individual names or other riskier assets that will likely perform well in a growing market. On the other hand, a high or increasing VIX may be a sign of heightened uncertainty ahead and it may be ideal to reduce exposure to risk assets in favour of cash and short-term securities. As an example, in February 2020 the VIX rose from 18.64 to close the month at 40.11 as COVID-19 spread rapidly across the globe with little clarity on how severe it would ultimately be. As the VIX continued to surge so too did the drawdown of the S&P 500, registering a fall of 8.41%, while the market was almost flat in January. In March, as conditions worsened, we saw the VIX reaching as high as 85.47, the highest outturn since the global financial crisis. Again, as the VIX exploded higher so too did the acceleration in the market decline, falling as much as 26.30% before it began its recovery.

Conclusion
The VIX can be a useful tool in gauging general market sentiment and investor confidence. Notwithstanding, It is important to note that this metric is not a crystal ball and there is no way to definitively predict the stock market using any one indicator. It is still important to understand the broader economic backdrop and the key driving factors affecting a security in deciding to make an investment decision.